In the wake of the Covid-19 pandemic, a seismic shift in the global economy has led to a protracted period of elevated interest rates, prompting the question: How long will this persist?
The unprecedented halt and subsequent reboot of industries worldwide disrupted supply chains, affecting the production, marketing, and distribution of goods and services on a global scale. Consequently, smaller manufacturers found themselves out of business, unable to keep pace with the evolving economic landscape.
As we now observe a gradual return to pre-pandemic spending patterns, there is an alarming imbalance between supply and demand. This supply-side shock has ignited higher inflation rates as the scarcity of goods and services propels prices upward. Global central banks responded by aggressively lowering interest rates and injecting substantial liquidity into the financial system.
However, the prolonged adherence to loose monetary policies inadvertently fueled global inflation. The consequences of surging inflation are keenly felt by low-income consumers whose purchasing power has been eroded by rising prices. The situation worsened with the steep increases in energy and food commodity prices following the Russia-Ukraine conflict in February 2022.
Given the multifaceted nature of the factors driving this inflationary surge, concerted and comprehensive efforts will be needed to curb it. Central banks are likely to maintain high interest rates until they are thoroughly convinced that inflation can be brought back in line with long-term trends. In tandem, fiscal authorities, grappling with mounting pandemic-related debts, are expected to promote austerity measures, including tax hikes and spending cuts, aimed at reducing the excess money supply from the COVID-era stimulus checks.
The implication is that interest rates are likely to stay elevated for a considerable period, though not indefinitely, to avoid fiscal unsustainability. This challenges the notion of achieving a "soft landing," where an economy can grow steadily without suffering adverse effects from higher interest rates. Tight labor markets and persistently elevated core and services inflation may necessitate central banks to maintain high rates longer than initially anticipated, potentially causing further economic disruptions.
Emerging economies are not impervious to the impact of higher US interest rates. Roughly 30 percent of Indonesia's annual debt issuance is denominated in foreign currency, primarily in US dollars. Elevated US interest rates translate to heightened debt servicing costs, amplifying borrowing expenses. Additionally, higher yields dissuade companies from refinancing their dollar-denominated debts, compelling them to deleverage, consequently bolstering short-term USD demand and weakening local currencies in the process.
“While the "higher for longer" theme permeates capital markets, there remains an undercurrent of optimism.”
Bank Indonesia must carefully juggle between keeping policy loose to sustain economic recovery or hiking rates to safeguard the stability of the financial system. In that case, Indonesia is fortunate to have relatively low debts and fiscal deficits, as well as an external balance that is healthier than its peers.
In the past three years, Indonesia has also built a strong local investor base that makes it less dependent on foreign investors. In the fixed-income markets, commercial lenders and BI have replaced foreign investors as the main sources of bond liquidity. In the stock markets, authorities have successfully promoted local investors whose activities are beginning to have a strong influence in swaying market directions.
Still, the expectations of lower US interest rates have been continuously pushed back as the US economy has proven more resilient than expected. Recent forecasts by Wall Street banks suggest that rate cuts may not occur until the second half of 2024. Additionally, the magnitude of the Federal Reserve's easing measures will play a pivotal role. If the Fed can successfully curb inflation without triggering a recession or a spike in unemployment, significant rate reductions may not be necessary.
It's worth noting that the Fed is well aware of the structural factors contributing to high inflation, such as de-globalization, disruptions in global supply chains, and underinvestment in energy. As a result, the Fed Funds Rate may only be lowered to 4% to 5% in the next easing cycle, a notable departure from the near-zero rates seen in previous cycles.
While the "higher for longer" theme permeates capital markets, there remains an undercurrent of optimism. Challenging times often give rise to transformative reforms. For bond investors, the realization dawns that the Fed may not come to the rescue as readily as it did in the past. Stock pickers are tasked with more discerning, bottom-up analysis. Policymakers are urged towards fiscal prudence. Companies, facing an elevated interest rate environment, must fortify their balance sheets and optimize their operations.
In conclusion, the question of how long interest rates will stay elevated is complex and multifaceted. It hinges on a delicate balance between addressing inflationary pressures and safeguarding economic stability. As the global economy grapples with these challenges, the path ahead remains uncertain, and adaptability and prudence will be key to navigating this evolving landscape.
